Supply and demand (43005)

Introduction

In
microeconomic
theory, the theory of supply and demand explains how the price and
quantity of goods sold in markets
are determined.

In
general where goods are traded in a market, prices of goods tend to
rise when the quantity demanded exceeds the quantity supplied at that
price, leading to a shortage, and conversely that prices tend to fall
when quantity supplied exceeds the quantity demanded. This causes the
market to approach an equilibrium point at which quantity supplied is
equal to the quantity demanded. Price is thus seen as a function of
supply curves and demand curves.

The
theory of supply and demand is important in the functioning of a
market
economy in that it explains the mechanism by which most resource
allocation decisions are made.

The
theory of supply and demand is usually developed assuming that
markets are perfectly
competitive. This means that there are many small buyers and
sellers, each of which is unable to influence the price of the good
on its own.

Supply and demand

1. A theory of price

What
is it? The theory of supply and demand is a theory of price and
output in competitive markets.

Adam
Smith had argued that each good or service has a "natural
price." If the price (of beer, for example), were above the
natural price, then more resources would be attracted into the trade
(brewing, in the example), and the price would return to its
"natural" level. Conversely if the price began below its
"natural" level.

The
modern theory of supply and demand differs from Smith's theory in
some important ways. Economists have made some progress in the last
200 years, and great economists such as John Stuart Mill and Alfred
Marshall (and many others) have played their part in the growth of
the modern theory of supply and demand. Nevertheless, the theory of
supply and demand is the modern expression of Smith's great insight
about "the natural price."

To
make a long story short, before about the 1850's most economists
accepted the Labor Theory of Value as the theory of the "natural
price." But there were some cases it did not apply to:
international trade, for example. John Stuart Mill suggested a
"supply and demand" solution for prices in international
trade. Other economists extended it to apply to prices in general.

Unlike
the "natural price," a long-run theory only, the theory of
supply and demand applies in the short run as well as the long.

2. Analysis of Markets

Our
approach to market theory will be first analytic and then synthetic.
To "analyze" something is to take it apart into its
components. Common sense tells us that competitive markets work
through an interaction of "supply and demand." Alfred
Marshall compared the supply and demand sides to the two blades of
scissors -- one won't cut by itself. You have to have both.

Accordingly,
we will first "analyze" competitive markets, by discussing
demand and supply separately. Then we will try to put them back
together (synthesize them) in order to understand the working of
competitive markets.

Thus,
in the next few pages, we will look at

demand

supply

equilibrium
of demand and supply

3. Simple Supply and Demand curves

This
can be illustrated with the following graph:

The
demand curve is the amount that will be bought at a given price. The
supply curve is the quantity that producers are willing to make at a
given price. As you can see, more will be purchased when the price is
lower (the quantity goes up). On the other hand, as the price goes
up, producers are willing to produce more goods. Where these cross is
the equilibrium. This will create a price of P and a quantity of Q
since that is where the two lines cross.

In
the figure straight lines are drawn instead of the more general
curves. See also Price
elasticity of demand.

4. Demand curve shifts

When
more people want something the demand curve will shift right. An
example of this would be more people suddenly wanting more coffee.
This will cause the demand curve to shift from the initial curve D0
to the new curve D1. This raises the equilibrium price from P0 to the
higher P1. This raises the equilibrium quantity from Q0 to the higher
Q1. In this situation, we say that there has been an increase in
demand which has caused an extension in supply.

Conversely,
if the demand decreases, the opposite happens. If the demand starts
at D1, and then decreases to D0, the price will decrease and the
quantity supplied will decrease - a contraction in supply.

5. Supply curve shifts

When
the suppliers costs change the supply curve will shift. For example,
if someone invents a better way of growing wheat, then the amount of
wheat that can be grown for a given price will increase. This creates
a shift from a original supply curve S0 to a new lower supply curve
S1 - a decrease in supply. This causes the equilibrium price to
decrease from P0 to P1. The equilibrium quantity increases from Q0 to
Q1 as the quantity demanded increases - an extension in demand.
Notice that the price and the quantity move in opposite directions in
a supply curve shift.

Conversely,
if the supply increases, the opposite happens. If the supply curve
starts at S1, and then shifts to S0, the price will increase and the
quantity will decrease as there is a contraction in demand.

6. Effects of being away from the Equilibrium Point

If
the price is set too high, such as at P1, then the quantity produced
will be Qs. The quantity demanded will be Qd. Since the quantity
demanded is less than the quantity supplied there will be a
oversupply problem. If the price is too low, then too little will be
produced to meet demand at that price. This will cause a undersupply
problem. Businesses responses to both these problems restores the
quantity and the price to the equilibrium. In the case of oversupply,
the businesses will soon have too much execess inventory, so they
will lower prices to reduce this.

7. Vertical Supply Curve

It
is sometimes the case that the supply curve is vertical. For example,
the amount of land in the world can be considered fixed. In this
case, no matter how much someone would be willing to pay for one more
acre of land, the extra can not be created. Also, even if no one
wanted all the land, it still would exist. These conditions create a
vertical supply curve. In the short run near vertical supply curves
are even more common. For example, if the Super Bowl is next week,
increasing the number of seats in the stadium is almost impossible.
The supply of tickets for the game can be considered vertical in this
case. If the organizers of this event underestimated demand, then it
may very well be the case that the price that they set is below the
equilibrium price. In this case there will likely be people who paid
the lower price who only value the ticket at that price, and people
who could not get tickets, even though they would be willing to pay
more. If some of the people who value the tickets less sell them to
people who are willing to pay more (i.e. scalp the tickets), then the
effective price will rise to the equilibrium price.

The
below graph illustrates a vertical supply curve. When the demand 1 is
in effect, the price will p1. When demand 2 is occurring, the price
will be p2. Notice that at both values the quantity is Q. Since the
supply is fixed, any shifts in demand will only effect price.

8.
Other market
forms

In
a situation in which there are many sellers but a single monopoly
supplier can adjust the supply and price of a good at will, the
monopolist will adjust the price so that his profit is maximised
given the amount that is demanded at that price. A similar analysis
using supply and demand can be applied when a good has a single
buyer, a monopsony,
but many sellers.

Where
there are both few buyers or few sellers, the theory of supply and
demand cannot be applied because both decisions of the buyers and
sellers are interdependent - changes in supply can affect demand and
vice versa. Game
theory can be used to analyse this kind of situation. See also
oligopoly.

The
supply curve does not have to be linear. However, if the supply is
from a profit maximizing firm, it can be proven that supply curves
are not downward sloping (i.e. if the price increases, the quantity
supplied will not decrease). Supply curves from profit maximizing
firms can be vertical or horizontal or upward sloping.

Standard
microeconomic assumptions can not be used to prove that the demand
curve is downward sloping. However, despite years of searching, no
generally agreed upon example of a good that has an upward sloping
demand curve has been found (also known as a Giffen
good). Non-economists sometimes think that this would not be the
case for certain goods. For example, some people will buy a luxury
car because it is expensive. In this case the good demanded is
actually prestige,
and not a car, so when the price of the luxury car decreases, it is
actually changing the amount of prestige so the demand is not
decreasing since it is a different good.

9. Discrete Example

The
above discussion of supply and demand can be thought of in terms of
individual people interacting at a market. Suppose the following
people exist:

Alice
is willing to pay $10 for a sack of potatoes.

Bob
is willing to pay $20 for a sack of potatoes.

Cathy
is willing to pay $30 for a sack of potatoes.

Dan
is willing to sell a sack of potatoes for $5.

Emily
is willing to sell a sack of potatoes for $15.

Fred
is willing to sell a sack of potatoes for $25.

There
are many possible trades that would be mutually agreeable to both
people, but not all of them will happen. For example, Cathy would be
willing to trade with Fred for any price between $25 and $30. If the
price is above $30, Cathy is not interested, since the price is too
high. If the price is below $25, Fred is not interested since the
price is too low. Of course, just because a trade is possible,
doesn't mean it will happen. Each of the sellers will try and get as
high of a price as possible, and each of the buyers will try and get
as low of a price as possible.

Imagine
that Cathy and Fred are bartering over the price. Fred offers $25
dollars for a sack of potatoes. Cathy is just about ready to agree
when Emily offers to sell a sack of potatoes for $24 dollars. Fred is
not willing to sell at $24 dollars, so he drops out. At this point,
Dan can offer to sell for $12. Emily won't sell for that amount so it
looks like the deal might go through. At this point however, Bob
steps in and offers $14 dollars. At this point, we have two people
who are willing to pay $14 dollars for a sack of potatoes (Cathy and
Bob), but only one person (Dan) willing to sell for $14 dollars. So
the price must go up because Cathy and Bob are both willing to pay
more than $14 dollars. As soon as the price hits $15 dollars, Emily
will be willing to sell so there are now two people willing to pay
$15 dollars and two people willing to sell at $15 dollars so the
trades can happen. But what about Fred and Alice? Well, Fred and
Alice are not willing to trade with each other since Alice is only
willing to pay $10 and Fred will not sell for any amount under $25.
Alice can't outbid Cathy or Bob to try and purchase from Dan so Alice
will not be able to get a trade with them. Fred can't underbid Dan or
Emily so he will not be able to get a trade with Cathy. In
otherwords, a stable equilibrium has been reached.

A
supply and demand graph could also be drawn from this. The demand
would be:

1
person is willing to pay $30 (Cathy).

2
people are willing to pay $20 (Cathy and Bob).

3
people are willing to pay $10 (Cathy, Bob, and Alice).

The
supply would be:

1
person is willing to sell for $5 (Dan).

2
people are willing to sell for $15 (Dan and Emily).

3
people are willing to sell for $25 (Dan, Emily, and Fred).

And
here is the graphs:

10. Application: Subsidy

A
subsidy is a payment from the government to a firm or individual in
the private sector, usually on the condition that the person or firm
that receives the subsidy produce or do something, or to increase the
income of a poor person.

For
our example, we will think of a subsidy for the production of corn.
(Some countries have paid subsidies for the production of grain in
order to make food cheaper for poor people). Let us suppose the
government pays corn farmers a dollar per bushel of corn, in addition
to whatever price they get in the marketplace. Figure 11 shows the
supply and demand for corn. A subsidy per unit of production works
pretty much like an excise tax, except in reverse. In particular, we
can look at the change from the point of view either of buyers or
sellers. In this example, we will look at the subsidy from the point
of view of the buyers. From their point of view, the subsidy is an
increase in supply.

A
Subsidy

Accordingly,
the figure shows the subsidy shifting the supply curve to the right,
from S1 to S2. The vertical distance is the amount of the subsidy:
one dollar per bushel. Demand is D, as usual. With supply S1 --
before the subsidy is given -- the market equilibrium price is p1 and
the equilibrium production is Q1. With supply S2 -- when the subsidy
is given -- the market equilibrium price is p2 and the equilibrium
production is Q2. We may conclude that a subsidy per unit of
production reduces the market price (though not quite by the full
amount of the subsidy) and increases the production of the item
subsidized.

Conclusion

How
are we to understand the market for a good such as beer, potatos, or
cheese? Common sense can tell us that the supply, demand, price and
quantity produced are interdependent, but how do they depend on one
another? The most general and important answer to that question in
modern economics is encapsulated in the "Supply and Demand"
model.

We
have defined "demand" as a relation between the price of
the good and the quantity consumers want to buy. Similarly, we have
defined "supply" as the relation between the price and the
quantity that producers want to sell. When we put these two concepts
together, we identify the market "equilibrium" with the
price and quantity at the intersection of the demand and supply
relations -- that is, a price just high enough that quantity demanded
is equal to quantity supplied, and the quantity corresponding to that
price.

In
a wide variety of historic and current examples, we find that we can
explain changes in quantities and prices as the equilibria of supply
and demand, with shifts in demand or in supply causing changes in
price and quantity. The changes in price and quantity are coordinated
in ways that can be understood and predicted, if we understand the
theory of supply and demand.